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Sunday, August 28, 2016

Yellen At Jackson Hole: Übergradualism Still The Baseline

Fed Chair Janet Yellen's speech at Jackson Hole may or may not get Fed watchers excited, but it seems to me that there was not a lot of new information. She made some hawkish noises, and it seems that we are due for another rate hike this year. I think December is the most plausible time, but it could be as early as September. In any event, the exact timing of the hike does not matter; the Fed is still following an übergradual rate hike path (hiking at a pace well below 25 basis points a meeting). Her discussion of policy options was mainly useful for those of us who are entertained by the collapse into incoherence of mainstream economics.

Fed Watching Summary

The following section of the speech caught the most attention for those who are focused on the path of interest rates.

Looking ahead, the FOMC expects moderate growth in real gross domestic product (GDP), additional strengthening in the labor market, and inflation rising to 2 percent over the next few years. Based on this economic outlook, the FOMC continues to anticipate that gradual increases in the federal funds rate will be appropriate over time to achieve and sustain employment and inflation near our statutory objectives. Indeed, in light of the continued solid performance of the labor market and our outlook for economic activity and inflation, I believe the case for an increase in the federal funds rate has strengthened in recent months.

I see nothing that is wildly inconsistent with the path of rate hikes embedded in the forward curve. It may be that the forward curve is too complacent, but people have been saying things that sound like that for a very long time. Unless there is an immediate recession -- or an acceleration in growth -- there is no reason to believe that the Fed will be raising rates more than a couple of times in 2017. It would take years to find out whether the pricing on the 10-year note is wildly out-of-line with respected to the path of rates that will be realised.

Reading the entrails of these speeches may or may not be useful for guessing when the next rate hike will come. Given the spacing of nine months to a year between a hikes, whether a rate hike is shifted by six weeks does not really matter for fixed income assets. Weirdly enough, equity market commentators seem to be more sensitive to the details of Fed policy than fixed income investors. My guess is that it is easier to make up exciting stories about the Fed than it is to try to explain the latest random gyration in equity prices.

Policy Options

The bulk of the speech focused on the policy options available to the Federal Reserve. Yellen argued that the current set of policy instruments are adequate to the task.

This was a way of pouring cold water on the academics pushing multiple agendas for monetary policy reform, including:

helicopter money;

raising the inflation target;

abolishing currency and having a negative policy rate;

increasing the number of instruments bought in Quantitative Easing;

targeting nominal GDP and having the Fed lose spectacular amounts of money in a nominal GDP futures market;

getting rid of all policymaking discretion and just have the policy rate set by a heuristic policy rule.

Chair Yellen does not have a lot of choice but to distance the Fed from these schemes. None of them are politically viable, nor would any of them do much good. A straightforward tax cut is a far more intelligent way to deal with a collapse in aggregate demand -- and that is exactly what was implemented in most of the affected developed countries in the aftermath of the Financial Crisis.

Furthermore, since these policies are ultimately ineffective, the central bank needs to pull them out of the cupboard during a crisis -- when no one has the time to analyse them properly. If they unveiled them now, they would be analysed to death, and no one would care when they are finally implement the policy. (This is my paraphrase of an argument by Gerard MacDonell. He argues that the Fed will announce a policy that they will hint that is "helicopter money" in the next cycle in order to get the gullible to bid up the price of risk assets. Since modern investors do not need a lot of prompting to bid up the price of risk assets, no one is going to question the fact that the Fed is not really implementing "helicopter money.")

The Monetary Policy Cupboard Is Bare -- So What?

In the current environment, monetary policy is going to be wildly ineffective when the next recession hits. Since I am not wedded to the theory that monetary policy is the only allowed response to a collapse in aggregate demand, I see no reason to care.

I would note that this is much more pessimistic than Chair Yellen on the policy tools currently available for the Fed. I previously noted the uselessness of QE. Furthermore, "forward guidance" is at best a joke.

Figure from Chair Yellen's Jackson Hole 2016 Speech.

The chart above shows the 70% confidence interval for the policy rate over a horizon of two years. Using the complete lack of information in that forecast as a baseline, an investor would have to be utterly clueless to price a ten-year bond solely based on the jawboning of central bank policy makers.

The lack of traction of the existing policy tools presumably has an implication for current policy. To once again crib another idea from Gerard, so long as the Fed does not believe their own propaganda about QE and forward guidance, they will have no choice but to err on the dovish side during this cycle.

However, this should not really concern anyone who is not directly interested in the path of central bank policy. As I noted above, the correct response to a sharp recession is a tax cut (active fiscal policy), and to allow the automatic stabilisers (passive fiscal policy) to work. This does not require us to hang economic policy solely upon the level of gullibility of financial market participants. It does mean that the Fed would remain far less relevant than many wish.

Yay For Productivity!

Chair Yellen's speech ended with a discussion of productivity that is simultaneously trivial yet profound.

Finally, and most ambitiously, as a society we should explore ways to raise productivity growth. Stronger productivity growth would tend to raise the average level of interest rates and therefore would provide the Federal Reserve with greater scope to ease monetary policy in the event of a recession. But more importantly, stronger productivity growth would enhance Americans' living standards. Though outside the narrow field of monetary policy, many possibilities in this arena are worth considering, including improving our educational system and investing more in worker training; promoting capital investment and research spending, both private and public; and looking for ways to reduce regulatory burdens while protecting important economic, financial, and social goals.

It appears that "productivity" is a concept that causes as much difficulty as "money" in economics. Is it not rather obvious that raising per capita output would raise the amount of goods and services ("living standards") per capita?

If we go past the standard mysticism associated with productivity, this is actually a good point. All of the problems that are allegedly being caused by inadequate monetary policy tools are really associated with defects in the real economy. Unless you wish to invoke Verdoorn's Law, non-targeted aggregate demand management is not going to help raise living standards. The mainstream exclusive focus on monetary policy is blinding us from looking at needed reforms to the real economy.

The reason why I dodged Verdoorn's law was for simplicity. My feeling is that monetary policy is too weak to make a large enough difference in output to see a measurable effect from the law. But that would turn into a big digression from the initial topic.

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